Thursday, 5 June 2014

Risk-Return Trade Off

One of 10 Principle of Financial Management is Risk- Return Trade Off. Risk-Return Trade Off is the principle that potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost.Therefore, people often use this term as High Risk, High Return instead of Risk-Return Trade Off.

In the world of business, when you invest more capital, the more potential of gain or loss you get. For example, there is a market share that valued $10. There are two possibility of this share in the future. Its value can be increased above $10, or can be decreased below $10. Depending on your analysis, you can get a capital gain or capital loss. The more you purchase the stock, the more you can get capital gain or capital loss. Let’s take a look at the condition when you purchase more or purchase less if the share value increase to $25:

Share Value at Purchase Price
Share Value at Sell Price
Capital Gain
Gain if Purchase less (100 Shares)
Gain if Purchase More (10000 Shares)
$10
$25
$15
$15 x 100 = $1,500
$15 x 10,000 = $150,000

I use the example when purchase less at 100 shares and 10,000 shares for purchase more. When you Purchase 100 Shares, you only get $1,500 capital gains, and you get $150,000 if purchased 10,000 shares. Here lies where Risk-Return Trade Off show off. The value $10 shares has potential to increase or decrease. When you believe that you can get more and purchase more you also purchase the risk in one bucket. When the value increase to $25, you get 150% gain. Percentage of this return remain unchanged instead of risk, while the amount you spent makes difference on your account.
Let’s take a look at the condition when you purchase more or purchase less if the share value decrease to $5:

Share Value at Purchase Price
Share Value at Sell Price
Capital Loss
Loss if Purchase less (100 Shares)
Loss if Purchase More (10000 Shares)
$10
$5
$5
$5 x 100 = $500
$5 x 10,000 = $50,000

I use the example when purchase less at 100 shares and 10,000 shares for purchase more. When you Purchase 100 Shares, you only lost $500 capital loss, and you lost $50,000 if purchased 10,000 shares. Here lies where Risk-Return Trade Off show off. The value $10 shares has potential to increase or decrease. When you believe that you can get more and purchase more you also purchase the risk in one bucket. When the value decrease to $5, you lost 50% of your account. Percentage of this return remain unchanged, while the amount you spent makes difference on your account.

Depending on how much you have control on your finance, you can change the amount of gain or loss in your account. Risk-Return Trade off just one of narrow mindset. You can also minimize the risk with much knowledge. Financial Risk is something that inevitable, but we can always improve our account with much knowledge.

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